Is the Taylor Rule Really a Rule?
By Arnold Kling
The Taylor rule says that the federal funds rate should equal 1.5 times the inflation rate plus .5 times the GDP gap plus 1. Currently the inflation rate is about 1.5 percent and the GDP gap is about -5 percent (using the average of the seven estimates of the gap provided in the recent update by Justin Weidner and John Williams).
So he gets that the Fed funds rate should be 0.75 percent.
If you had asked me, I would have used different numbers. I think that core inflation (the CPI excluding food and energy) has been running at about 0.5 percent. I look at an unemployment rate of 9.5 percent and think that is 5 percent above full employment. Using Okun’s Law (the 2-for-1 version), that says that GDP is 10 percent below its full-employment level. So I get that the Fed funds rate should be -3.25.
(I asked my high school econ class to read Bernanke’s August 27th speech and ask questions. One student asked what Bernanke meant be conventional vs. unconventional monetary policy, and I did not know quite how to answer, since class has just started and I have not explained anything about monetary policy. I think this -3.25 percent calculation would be a good way to introduce the conversation about conventional vs. unconventional.)
The point is not to claim that the assumptions I would have used are more reasonable than Taylor’s. The point instead is to suggest that there is a lot more play in his “rule” than you might otherwise presume. The GDP gap, in particular, is a very elusive fellow to estimate, particularly when you are far from full employment.
Just intuitively, if the inflation rate is at a 50-year low and the unemployment rate is near a 50-year high, it’s hard to believe that the monetary dials are set right.
All of the foregoing assumes, of course, that you believe that AD is the problem. I am willing to take a Pascal’s wager approach to that assumption, but I personally think that what we have is a huge destruction of labor capital. In Taylor-rule terms, that means that the GDP gap is much, much smaller than the Okun’s Law calculation suggests.